Speech

For release on delivery IQiOOj A.M. , E.D.T. Statement by Paul A. Volcker Chairman, Board of Governors of the Federal Reserve System before the Committee on Banking, Housing, and Urban Affairs United States Senate July 22, 1980 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis I am pleased to be here today to review the conduct of monetary policy and to report on the Federal Reserve's economic objectives for the year as a whole, as well as its tentative thinking on policy goals for 1981. Our so-called "Humphrey- Hawkins Report" has already been distributed to you. I would like simply to add some personal perspective this morning on the course of monetary policy, in the context of the economic prospects and choices facing us with respect to other policy instruments. Seldom has the direction of economic activity changed so swiftly as in recent months. Today the country is faced simul- taneously with acute problems of recession and inflation. There have been unprecedented changes in interest rates and the imposition and removal of extraordinary measures of credit restraint. The fiscal position of the Federal Government is changing rapidly. In these circumstances, confusion and uncertainty can arise about our goals and policies, not just those of the Federal Reserve, but of economic policy generally. Therefore, I particularly welcome this opportunity to emphasize the under- lying continuity in our approach in the Federal Reserve and its relationship to other economic policies, matters that are critical to public understanding, and expectations. The Federal Reserve has been, and will continue to be, guided by the need to maintain financial discipline — a discipline concretely reflected in reduced growth over time of the monetary and credit aggregates — as part of the process of restoring price Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis -2- stability. As I see it, this continuing effort reflects not simply a concern about the need for greater monetary and price stability for its own sake — critical as that is. The experi- ence of the 1970fs strongly suggests that the inflationary process undercuts efforts to achieve and maintain other goals, expressed in the Humphrey-Hawkins Act, of growth and employment. As you know, our operating techniques since last October have placed more emphasis on maintaining reserve growth consistent with targeted ranges for the various Ms, with the implication interest rates might move over a wider range. Those targets were reduced this year as one step toward achieving monetary growth consistent with greater price stability. For several months after the new techniques were introduced in October, the various aggregates were remarkably close to the targeted ranges. At that time, and for months earlier, you will recall wide- spread anticipations of recession. Nevertheless, reflecting a variety of developments at home and abroad — including an enormous new increase in oil prices, Middle-Eastern political volatility, and interpretations of adverse budgetary developments — there was a marked surge in the most widely disseminated price indices and in inflationary expectations in the early part of this year. Those expectations in the short run probably helped to support business activity for a time; in particular, consumer spending relative to income remained very high, with the consequence of Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis -3- historically (and fundamentally unhealthy) low savings rates and high debt ratios. Speculation was rife in commodity markets. Spending and speculative activities of that kind are ultimately unsustainable. But they carried the clear threat of feeding upon themselves for a time, contributing among other things to a further acceleration of wage rates and prices. In that way, inflation threatened to escalate still further in a kind of self-fulfilling prophecy, posing the clear risk that the subsequent economic adjustment would be still more difficult. Credit markets reflected these developments and attitudes. Bond prices fell precipitously. Long-term money — including mortgages — became difficult to raise. Partly as a consequence, short-term demands for credit ballooned in the face of sharply rising interest rates, at the expense in some instances of further weakening business balance sheets. That heavy borrowing also was reflected in acceleration in the money and credit aggregates during the winter. An attempt to stabilize interest rates by the provision of large amounts of bank reserves through open market operations to support even more rapid growth in money would probably have been doomed to futility even in the short-run, for it could only have fed the expectations of more inflation. It would certainly have been counter-productive in terms of the overriding long-term need to combat inflation and inflationary anticipations. Instead, con- sistent with our basic policy approaches and techniques, the Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis -4- Federal Reserve resisted accommodating the excessive money and credit growth. During this period of rising inflation and interest rates, the Administration and the Congress also appropriately and intensively reviewed their own budget planning* Coordinated with the announcement of the results of that broad governmental effort and the decision of the President to invoke the Credit Control Act of 1969 the Federal Reserve announced on March 14 f a series of exceptional, temporary measures to restrain credit growth, reinforcing and supplementing our more traditional and basic instruments of policy. The demand for money and credit dropped abruptly in subsequent weeks, reflecting the combined cumulative effects of the tightening of market conditions, the announcement of the new actions, and the rather sudden weakening of economic activity. In response, interest rates within a few weeks fell about as fast — in some instances faster and further — than they had risen in earlier months. Growth in the aggregates slowed, and for some weeks M-1A and M-1B turned sharply negative. There is no doubt in my mind that these lower levels of interest rates can play a constructive role in the process of restoring a better economic equilibrium and fostering recovery. Indeed, there is already evidence — if still tentative — that homebuilding and other sectors of the economy sensitive to credit costs and availability are benefitting. Meanwhile, progress is being made toward reducing consumer indebtedness relative to Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis -5- income and toward restructuring corporate balance sheets as bond financing has resumed at a very high level. The sharp improvement in credit market conditions has been accompanied by slower rates of increase in consumer and producer prices, helping to quiet earlier fears of many of an explosive increase in inflation. The suddenness of the change in market conditions has, however, raised questions in some minds as to whether the interest rate declines were in some manner "contrived" or "forced" by the Federal Reserve •— whether, to put it bluntly, the performance of the markets (together with the phased removal of the special credit restraints) reflects some weakening of our basic commitment to disciplined monetary policy and the priority of the fight on inflation. These perceptions are not irrelevant, for they could affect both expectations and behavior, most immediately in the financial and foreign exchange markets, but also among businessmen and consumers. The facts seem to me quite otherwise. Growth in money and credit since March has certainly not exceeded our targets; the M-l measures have in fact been running below our target ranges. Bank credit has declined in recent months; while the decline in commercial loans of banks can be explained in part by exceptionally heavy bond and commercial paper issuance by corporations, there is simply no evidence of excessive rates of credit expansion currently. In these circumstances, it is apparent that interest rates have responded — and have been Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis -6- permitted to respond — not to any profligate and potentially inflationary increase in the supply of money, but to changes in credit demands, and (so far as long-term interest rates are concerned) to reduced inflationary expectations. It is in that context — with credit demands reduced and growth of credit running well within our expectations and targets that the special credit restraint programs simply served no further purpose. Those measures were invoked to achieve greater assurance that credit growth would in fact slow, and that appro- priate caution would be observed in credit usage. The special restraints are inevitably cumbersome and arbitrary in specific application. They involve the kind of arbitrary intrusion into private decision-making and competitive markets that should not be part of the continuing armory of monetary policy; their use was justified only by highly exceptional circumstances - circumstances that no longer exist. Our normal and traditional tools of control (which in fact have been solidified by the Monetary Control Act passed earlier this year) are intact and fully adequate to deal with foreseeable needs. Neither the decline in interest rates nor the removal of the special restraints should be interpreted as an invitation to consumers or businessmen to undertake incautious or imprudent borrowing commitments, or as lack of concern should excessive growth in money or credit reappear. That is not happening now. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis -7- But markets (and the public at large) remain understandably extremely sensitive to developments that might aggravate inflationary forces. As we saw only a few months ago, consumers and businessmen will react quickly in their lending and borrowing behavior to that threat. While the recent easing of financial pressures helps provide an environment conducive to growth, we should not be misled. A resurgence of inflationary pressures, or policies that would seem to lead to that result, would not be consistent with main- tenance of present — much less lower — interest rates, receptive bond markets, and improving mortgageavailability. We in the Federal Reserve believe the kind of commitment we have made to reduce monetary growth over time is a key element in providing assurance that the inflationary process will be wound down, I noted earlier the money stock actually dropped sharply during the early spring. In a technical sense, working on the supply side, we provided substantial reserves through open market operations during that period, but commercial banks, finding demands for credit and interest rates dropping rapidly, repaid discount window borrowings as their reserve needs diminished. In general terms, it seems clear that, at least for a time, the demand for money subsided (much more than can be explained on the basis of established relationships to business activity and interest rates) apparently because consumers and others hastened debt repayment at the expense of cash balances and because the earlier interest rate peaks had induced individuals to draw on Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis -8- cash to place the funds in investment outlets available in the market. As the Report illustrates, M-l growth has clearly resumed, and the broader aggregate M-2 is now at or above the mid-point of its range. In the judgment of the Federal Open Market Com- mittee, forcing reserves on to the market in recent weeks simply to achieve the fastest possible return to, say, the mid-point of the M-l ranges may well have required early reversal of that approach, have been inconsistent with the close-to-target performance of the broader aggregates, and therefore led to unwarranted interpretations and confusion about our continuing objectives. Depending on the performance of the broader ag- gregates and our continuing analysis of general economic developments, the FOMC is in fact prepared to contemplate that M-l measures may fall significantly short of the mid-point of their specified ranges for the year. I have emphasized the Committee's intention to work toward the lower levels of monetary expansion over time* In reviewing the situation this month, the Committee felt that, on balance, it would be unwise to translate that intention into specific numerical targets for 1981 for the various Ms at this time. That view was strongly reinforced by certain important technical uncertainties related to the introduction of NOW accounts nationwide next January, as well as by the need to assess whether the apparent shift in demand for cash in the spring persists. At the same time, the general nature of the potential problems and dilemmas for 1981 and beyond is clear enough? these are important questions, not just for monetary policy but for the full armory of public policy. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis The targets for the monetary aggregates are designed to be consistent with, and to encourage, progress toward price stability without stifling sustainable growth. But in the short-run, the demand for money (at any given level of interest rates) tends to be related not to prices or real output alone, but to the combined effects of both — the nominal GNP. If recovery and expansion are accompanied by inflation at current rates or higher, pressures on interest rates could develop to the point that consistency of strong economic expansion with reduced monetary growth would be questionable. Obviously, a satisfactory answer cannot lie in the direction of indefinitely continued high levels of unemployment and poor economic performance. But ratifying strong price pressures by increases in the money supply offer no solution; that approach could only prolong and intensify the inflationary process — and in the end undermine the expansion. The insidious pattern of rising rates of inflation and unemployment in succeeding cycles needs to be broken; with today's markets so much more sensitized to the dangers of inflation, economic performance would likely be still less satisfactory if that pattern emerges again. The only satisfactory approach must lie in a different direction — a credible effort to reduce inflation further in the period ahead, and policies that hold out the clear prospect of further gains over time, even as recovery takes hold. We are now in the process of seeing the inflation rate, as recorded in the consumer and producer price indices, drop to or Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis -10- even below what can be thought of as the underlying or core rate of inflation of 9 to 10 percent. That core rate is roughly determined by trends in wages and productivity. We can take some satisfaction in the observed drop of inflation, and the damping of inflationary expectations. But the hardest part of this job lies ahead, for we now need to make progress in improving productivity or reducing underlying cost and wage trends — as a practical matter both — to sustain the progress. The larger the productivity gain, the smoother will be the road to price stability — partly because that is the only way of achieving and sustaining growth in real incomes needed to satisfy the aspirations of workers. Put in that light, the importance of a concerted set of policies to reconcile our goals — not simply relying on monetary policy alone — is apparent. While those other policies clearly extend beyond the purview of the Federal Reserve, they obviously will bear upon the performance of financial markets and the economy as the Federal Reserve moves toward reducing over time the rate of growth in money and credit. In that connection, I recognize the strong conceptual case that can be made for action to reduce taxes. Federal taxes already account for an historically large proportion of income. With inflation steadily pushing income tax payers into higher brackets and with another large payroll tax increase to finance social security scheduled for 1981, the ratio will go higher still. The thesis that this overall tax burden — and the way our tax structure impinges on savings and investment, Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis -11- costs and incentives — damages growth and productivity seems to me valid. Moreover, depending on levels of spending and the business outlook next year, the point can be made that the implicit and explicit tax increases in store for next year will drain too much purchasing power from the economy, unduly affecting prospects for recovery. But I must also emphasize there are potentially adverse consequences that cannot be escaped — to ignore them would be to jeopardize any benefits from tax reduction, and risk further damage to the economy. Whatever the favorable effects of tax reduction on incentives for production and productivity over time, the more immediate consequences for the size of the Federal deficit, and potentially for interest rates and for sectors of the economy sensitively dependent on credit markets, need to be considered. Many of the most beneficial effects of a tax reduction depend upon a conviction that it will have some permanence, which in turn raises questions of an adequate commitment to complementary spending policies and appropriate timing. We are not dealing with a notion of a "quick fix" over the next few months for a recession of uncertain duration, but of tax action for 1981 and beyond at a time when Federal spending levels, even for fiscal 1981, appear to be a matter of consid- erable uncertainty, with the direction of movement higher. Experience is replete with examples of stimulation, undertaken with the best motives in the world, that has turned out in retrospect to have been ill-timed and excessive. Given Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis -12- the demonstrable frailty of our economic forecasting, it takes a brave man indeed to project with confidence the precise nature of the budgetary and economic situation that will face the nation around the end of this year. Moreover, an intelligent decision on the revenue side of the budget implies knowledge of the spending priorities of an ^administration and a Congress, a matter that by the nature of things can only be fully clarified after the election* For all the developing consensus on the need for "supply side" tax reduction — and I share in that consensus — some time seems to me necessary to explore the implications of the competing proposals and to reduce them to an explicit detailed program for action. I have emphasized the need to achieve not only productivity improvement but also a lower trend of costs and wages; despite its importance, I have seen relatively little discussion in the current content of how tax reduction plans might be brought to bear more directly on the question of wage and price increases. The continuing sensitivity of financial markets, domestic and international, to inflationary fears is a fact of life. It adds point and force to these observations and questions. Tax and budgetary programs leading to the anticipation of excessive deficits and more inflation can be virtually as damaging as the reality in driving interest rates higher at home and the dollar lower abroad. I believe it is obvious from these remarks that a con- vincing case for tax reduction can be made only when crucial Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis -13- questions are resolved -— questions that are not resolved today. The appropriate time for decision seems to me late this year or early 1981. Fiscal 1982 as well as fiscal 1981 spending plans can be clarified. We will know if recovery of business is firmly underway. There will have been time to develop and debate the most effective way of maximizing the cost-cutting and incentive efforts of tax reduction, and to see whether a tax program can contribute to a consensus — a consensus that has been elusive in the past — on wage and pricing policies consistent with progress toward price stability. To go ahead prematurely would surely risk dissipating the potential benefits of tax reduction amid the fears and actuality of releasing fresh inflationary forces. I have spoken before with this Committee and others about the need for changes in other areas of economic policy to support our economic goals. Paramount is the need to reduce our dependence on foreign oil — a matter not unrelated to tax policy. We need to attack those elements in the burgeoning regulatory structure that impede competition or add unnecessarily to costs. And I believe it would be a serious mistake to seek relief from our present problems by retreat to protectionism, at the plain risk of weakening the forces of competition, the pressures on American industry to innovate, and undermining the attack on inflation. We are now at the critical point in our efforts to reduce inflation while putting the economy back on the path to sustainable growth in the 19 80fs. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis -14- I sense the essential objectives are widely understood and agreed — the need to wind down inflation even as recovery proceeds; the importance of restoring productivity and increasing incentives for production and investment; the maintenance of open, competitive markets; a substantial reduction in our dependence on foreign energy. You know as well as I how much remains to be done to convert glittering generalities into practical action: to achieve and maintain the necessary fiscal discipline, to make responsible tax reduction and reform a reality, to conserve energy and increase domestic sources, to tackle the regulatory maze. But I also know there is no escape from facing up to the many difficulties. Our policies must be coherently directed toward the longer-range needs. In that connection, I believe that economic policies, public and private, should recognize that the need for discipline and moderation in the growth of money and credit provides the framework for decision-making in the Federal Reserve. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis

Paul A. Volcker (1980, July 21). Speech. Speeches, Federal Reserve. https://whenthefedspeaks.com/doc/speech_19800722_volcker

@misc{wtfs_speech_19800722_volcker,
  author = {Paul A. Volcker},
  title = {Speech},
  year = {1980},
  month = {Jul},
  howpublished = {Speeches, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/speech_19800722_volcker},
  note = {Retrieved via When the Fed Speaks corpus}
}